Fixed-Income Security Definition, Types, and Examples

What Are Fixed-Income Securities?

A fixed-income security is an investment that provides a return through fixed periodic interest payments and the eventual return of principal at maturity. Unlike variable-income securities, where payments change based on an underlying measure, such as short-term interest rates, the returns of a fixed-income security are known.

Understanding Fixed-Income Securities

Fixed-Income securities are debt instruments that pay a fixed amount of interest, in the form of coupon payments, to investors. The interest payments are commonly distributed semiannually, and the principal is returned to the investor at maturity. Bonds are the most common form of fixed-income securities.

A bond is an investment product corporations and governments issue to raise funds to finance projects and fund operations. Corporate and government bonds have various maturities and face values. The face value is the amount the investor will receive when the bond matures. Corporate and government bonds trade on major exchanges and usually are listed with $1,000 face values, also known as the par value.

Credit Rating of Fixed-Income Securities

Bonds are assigned different credit ratings based on the financial viability of the issuer. Credit ratings are part of a grading system performed by credit-rating agencies. These agencies measure the creditworthiness of corporate and government bonds and the entity's ability to repay these loans. Credit ratings are helpful to investors because they define the risks involved in investing.

Bonds can either be investment-grade or non-investment-grade bonds. Investment grade bonds are issued by stable companies with a low risk of default and, therefore, have lower interest rates than non-investment grade bonds. Non-investment grade bonds, also known as junk bonds or high-yield bonds, have lower credit ratings due to a probability of default by the issuer. Investors receive a higher interest rate from investing in junk bonds for assuming the higher risk of these debt securities.

Types of Fixed-Income Securities

Treasury Notes

Treasury notes (T-notes) are issued by the U.S. Treasury and are intermediate-term bonds that mature in two, three, five, or ten years. T-Notes usually have a face value of $1,000 and pay semiannual interest payments at fixed coupon rates or interest rates. The interest payment and principal repayment of all Treasurys are backed by the full faith and credit of the U.S. government, which issues these bonds to pay debts.

Treasury Bond

The U.S. Treasury also issues Treasury bonds (T-bond) which mature in 30 years. Treasury bonds typically have par values of $10,000 and are sold on auction on the website TreasuryDirect.

Treasury Bills

Short-term fixed-income securities include Treasury bills. The T-bill matures within one year from issuance and doesn't pay interest. Instead, investors buy the security at a lower price than its face value or a discount. When the bill matures, investors receive the face value amount. The interest earned or return on the investment is the difference between the purchase price and the face value amount of the bill.

Municipal Bond

A municipal bond is issued by states, cities, and counties to fund capital projects, such as roads, schools, and hospitals, commonly sold with a $5,000 face value. The interest earned from these bonds is exempt from federal income tax. The interest earned on a "muni" bond may be exempt from state and local taxes if the investor resides in the state where the bond is issued. The muni bond has several maturity dates in which a portion of the principal comes due in intervals until the entire principal is repaid.

Certificate of Deposit

A bank issues a certificate of deposit (CD). In return for depositing money with the bank for a predetermined period, the bank pays interest to the account holder. CDs have maturities of less than five years and typically pay lower rates than bonds but higher rates than traditional savings accounts. A CD carries Federal Deposit Insurance Corporation (FDIC) insurance up to $250,000 per account holder.

Corporate Bonds

Corporate bonds are debt securities issued by companies to raise funds. Unlike company stocks, bond investors have no voting rights or equity in the company. Bonds are classified based on their maturity period. Short-term bonds are held for less than three years, medium-term for four to ten years, and long-term for more than ten years. Bonds are classified as investment or non-investment grade depending on the company's credit rating.

Preferred Stock

Companies issue preferred stock that provides investors with a fixed dividend, set as a dollar amount or percentage of share value on a predetermined schedule. Interest rates and inflation influence the price of preferred shares, and shares have higher yields than most bonds due to their longer duration.

Advantages and Disadvantages of Fixed-Income Securities

Advantages

Fixed-income securities provide steady interest income to investors, reduce risk in an investment portfolio and protect against volatility or fluctuations in the market. Equities are traditionally more volatile than bonds so investors may allocate a portion of their portfolios to fixed-income investments to reduce their risk level. Fixed-income securities are also available in mutual funds and exchange-traded funds (ETFs).

The prices of bonds and fixed-income securities increase and decrease. Although the interest payments of fixed-income securities are steady, their prices are not guaranteed to remain stable throughout the life of the holding. If investors sell a fixed-income security before maturity, gains or losses are based on the difference between the purchase price and the sale price.

The U.S. Treasury guarantees government fixed-income securities, considered safe-haven investments. Corporate bonds depend on the financial viability of a company and have a higher risk of default than government bonds. However, corporate bonds are more likely to be repaid if a company declares bankruptcy since bondholders will be repaid before common stockholders.

Disadvantages

Fixed-income securities commonly have low returns and slow capital appreciation or price increases. The initial principal amount is often inaccessible, particularly with long-term bonds with maturities greater than ten years.

Fixed-income securities provide a fixed interest payment regardless of where market interest rates move. An investor that purchased a bond paying 2% per year will lose income if market interest rates rise above 4%. Inflation may erode the return on fixed-rate securities if the inflation rate is higher than the interest rate of the fixed-income instrument.

All bonds have credit or default risk since the securities are tied to the issuer's financial viability. Investing in international bonds can increase the risk of default if the country is economically or politically unstable.

Real-World Example

Treasury bonds are long-term bonds with a maturity of 30 years. T-Bonds provide semiannual interest payments and usually have $1,000 face values. A 30-year Treasury bond was issued on February 15, 2023, with a rate of 3.625%. Investors are paid $36.25 on their $1,000 investment each year. The $1,000 principal is repaid in 30 years.

A 10-year Treasury note was issued on February 15, 2023, with a rate of 3.5%. The bond also pays semiannual interest payments at fixed coupon rates and usually has a $1,000 face value. Each bond would pay $35.00 per year until maturity.

The Bottom Line

A fixed-income security is an investment that provides a steady interest income stream for a certain period. Types include government bonds, corporate bonds, or fixed-income ETFs. Fixed-income securities are rated by credit agencies that assess the default risk for investors. These investments typically pay a lower rate of return than other investments.